Earnings season is here. If revenues don't grow, look out below

The unofficial start to third-quarter reporting season kicks off when everyone's favorite aluminum giant, Alcoa (AA), releases results after Wednesday's close. And the market just knows it's going to be the best earnings season ever! Witness the nearly 250-point burst in the Dow Jones Industrial Average ($INDU) over Monday and Tuesday.

Not to be Captain Bringdown, but in actuality it's going be a lousy earnings season, if you care about a little thing called profit growth. Analysts, on average, expect earnings for the S&P 500 ($INX) to drop 25 percent in the third quarter compared with the same period in 2008, according to Thomson Reuters. Stocks are supposed to represent future earnings (or cash flow or dividends), so where's all this ardor for equities coming from?
It's all about investors having short horizons -- and betting that companies can beat the Street's low expectations, says Rodney Johnson, portfolio manager at AdvisorShares and the actively managed Dent Tactical exchange-traded fund (DENT).

"In the short term, people are looking at their shoelaces," Johnson says. "So they are going to be looking at the bottom line and be very happy. The top line? That's going to be ominous."

You see, in the second quarter more than 70 percent of companies beat Street estimates, a much greater percentage than the norm. There were a bunch of reasons for that. Neither corporate management teams nor Wall Street analysts are clairvoyant, for one thing. Besides, it's not like either group has any incentive but to tamp down investors' expectations. Why embarrass yourself or set your stock up for a sell-off?

But most important was that the better-than-expected earnings came from slashing and burning costs. Human beings experience this corporate adjustment to the income statement in the form of mass layoffs -- and therein lies the rub. Earnings topped estimates last quarter because of costs cuts, not revenue growth. And people without jobs -- or in fear of losing a job -- can't exactly be counted on to spend more.

"There's an old axiom in business that you can't save your way to profitability," Johnson says. "Cost cuts look great for three months. But we are bumping up against 10 percent unemployment. That is a huge anchor."

Even so, the market and the economy are not the same thing. Companies have shed costs so mercilessly that margins are potentially spring-loaded, meaning even a slight uptick in revenue could be a huge boon to bottom lines. That's why Johnson thinks the market will get a pop out of earnings -- and then probably stumble when the grim reality of holiday sales sets in later.

Still, some reason for optimistism regarding revenue is warranted, notes Jeffrey Kleintop, chief market strategist at LPL Financial in Boston. Last quarter, gross domestic product was negative with little revenue growth to go around, he told clients Tuesday. But in the third quarter, GDP is likely to have been positive, "and we expect to see better top-line growth helping to drive results," Kleintop wrote.Let's hope he's right. The only thing the market likes better than better-than-expected earnings is a better-than-expected outlook. (Put the two together in a so-called beat-and-raise quarter, and that's the trader's equivalent of a spa day.)

Larry Rosenthal, president of Financial Planning Services, an advisory in Manassas, Va., thinks this quarter will show that the consumer is back in an "adequate" manner, providing just enough spending to make the market quite happy with results. "Consumers still need to get over the speed bumps of job creation and more stability in real estate prices," he says. "We are not out of the woods yet, but we are making progress."

Rosenthal counts himself among the bulls, but he still urges caution and more caution ahead. October is a historically volatile month to begin with, and things always get choppier during earnings season. So maintain discipline, buy the dips and dollar-cost average your way into any position, he says.